Noel Whittaker's Blog It’s been another volatile week in world stock markets – caused mainly by the American Federal Reserve continuing its policy of increasing interest rates. This has caused a rout in the bond market, which has somehow led to a fall in the share market, with the papers claiming that investors are fleeing to the safety of gold.
I have never been a fan of gold, and certainly don’t see it as a safe haven, but that’s really a matter for the individual investor. My topic today is bonds.
The confusing thing about bonds is that they fall in price as interest rates rise. Therefore you may see headlines such as “bond market in chaos as yields jump” or read that “bond prices fell as interest rates moved higher on inflationary fears”.
This is because a bond is an investment that offers a capital sum repayable at a fixed future date, combined with a fixed income until that date.
If both interest and principal are government guaranteed you may feel they are a very secure investment, and there is little doubt you will receive the face value of the bond when it eventually matures.
The big problem is inflation – it will erode the value of the bond’s income, as well as the principal that is repaid on maturity.
Suppose you buy a 2.7% $100 000 government bond with 10 years to maturity. This means that it carries a guarantee from the government that it will be redeemed for $100 000 in 10 years and will pay you interest at 2.7% per annum until then. If inflation runs at 3% per annum the value of that $100 000 you will receive in 10 years is only $74,000 in today’s dollars. Furthermore, the real value of the income will also reduce by 3% a year.
Whether you should switch part of your money to bonds is something to discuss with your adviser, and the decision should turn on your risk profile and your belief as to where inflation is heading.
Just keep in mind that a Commonwealth Government bond maturing in five years purchased today will yield around 2.2%, – a negative yield if inflation is 3%. The Australian share market is currently delivering a yield of around 4.5% plus long term capital growth.
For my money, despite the uncertainty of a stock market, I’d rather have the higher yield.